Coal and Shale Gas: America's Energy Siblings Are Locked in Rivalry

Competition is supposed to make competitors stronger, but when it
comes to the battle between coal and shale gas for supremacy as the
United States' power-generating fuel of choice, the rivalry instead has
each commodity holding the other down.

Coal is the reigning champ
is this competition, having provided at least 50% of the electricity
consumed in the United States for many decades. Coal and nuclear plants
have long worked together to provide the nation with its all-important
baseload power; natural gas and renewables contribute to help meet
peak-demand needs, but neither has come close to challenging coal's grip
on power.

But then horizontal drilling and multi-stage fracturing
unlocked trillions of cubic feet of natural gas from shale formations
across North America. Suddenly the continent was flooded with gas; and
as supplies overwhelmed demand, a commodity that traded as high as $13
per MMBtu just four years ago saw its value drop as much as 85%.

At
the same time, international demand kept coal prices pretty strong.
Faced with a choice, utilities started to switch from coal to natural
gas. Coal's grip on US power-generation supremacy started to fade – from
a high of 57% in 1985, coal's contribution to US power needs slipped to
42% last year. Today coal is providing only 37% of US electricity.

As
demand for coal dropped, coal prices started to lose ground. In the
past 12 months, prices for Appalachian coal have fallen 24% while coal
from the Powder River Basin in Montana and Wyoming has lost 45% of its
value.

It's become a race for the bottom. Ultracheap gas started
to displace coal, coal prices fell to remain competitive, and now the
two are fighting to simply tread water.

The Switch to Gas

As
gas flooded the continent and prices plunged, it only made sense for US
utilities to take advantage of this inexpensive alternative fuel.
Southern Co., Xcel Energy, American Electric Power, and Dominion
Resources are among the US power-generators that have taken advantage of
low natural-gas prices to displace some of their coal-fired generation.
Some of these companies simply started making more use of gas-fired
plants that had previously only been used to serve peak-power demand.
Others operate combined cycle coal-gas plants, which can burn either
fuel. And some actually built new gas-fired units to replace older, less
efficient facilities, some of which were being forced to close because
of increasingly stringent environmental regulations.

Southern's
switch to gas makes for a good example. Southern ran its combined cycle
gas turbine fleet at a near-record 70% of capacity during the first
quarter of the year, doubling the plants' typical use. This degree of
transition has the utility on pace to consume more gas than coal this
year for the first time in its 100-year history. As a result the company
expects to derive 47% of its power from gas and only 35% from coal.
Five years ago the company relied on coal for 70% of its generation; gas
provided just 16% of its power.

No matter how you look at it,
utilities are using a lot more gas than they used to. Barclays Capital
estimates that 7 billion cubic feet of gas is being burned each by US
utilities that used to burn coal to generate those watts. US Energy
Information Administration data show power companies consuming 34% more
gas this February than a year earlier. Credit Suisse estimates power
plants ate up 5 billion cubic feet more gas each day in the first three
months of the year compared to Q1 of 2011.

However, the switchover
phase is almost complete. Utilities have transitioned their combined
cycle plants, restarted their idled gas capacities, and committed as
much to new gas plants as they are probably willing to commit, given
natural gas' tendency for extreme price volatility. And utilities will
only start to make a dent in America's massive stockpiles of natural gas
if the trend to increased gas consumption can continue through this
year. Credit Suisse figures the power industry will need to burn at
least 4.5 billion cubic feet more per day above 2011 levels to create a
notable drawdown in gas inventories, something that analysts peg as
unprecedented but not out of the question.

So the switch is barely easing the gas-supply glut…but it is definitely hurting coal prices.

What Happens Next

As
utilities switched to gas, demand for coal started to decline, and with
declining demand comes falling prices. By January coal producers could
no longer ignore the trend and started idling mines. Patriot Coal idled
its Big Mountain mine, Alpha Natural Resources closed four mines, and
many other companies cut back on production volumes.

Coal
production in the United States is now down 8% compared to this time
last year. Shares of Peabody Energy, the biggest coal producer in the
United States, have dropped from $70 to $29. Arch Coal shares have
fallen from $35 to less than $10. Several coal producers have announced
losses in the hundreds of millions.

I like to say that the cure
for low prices is low prices. Low commodity prices force production
cuts, which reduce supplies and help to define a pricing floor based on
the cost of production. Eventually, reduced supplies fall behind
building demand, and prices are forced back up again.

The
interesting thing about this situation is that there are two commodities
competing to define the pricing floor. It's like a manufacturing
battle, where two companies keep undercutting each other's prices until
one goes under and the survivor gets all the business. In this case,
neither fuel is going to go under – both will undoubtedly play important
roles in electricity generation in the United States for many years.
Instead, the competition will simply keep a tight lid on prices for
years.

For example, in the last month natural gas prices posted an
impressive rally, gaining as much as 40% after bottoming below $2 per
MMBtu. That rally has now stalled, blocked from continued ascent by two
serious obstacles: coal prices and shut-in gas production.

Coal
prices matter because natural gas needs to remain competitive with coal.
Utilities only switched to gas because it was cheaper, but with gas'
rally that economic edge is wearing thin. In fact, our calculations show
that the two fuels are almost equivalent in terms of energy economics.

Since
April 20 Central Appalachian coal has been priced at US$60.90 per ton.
Each pound of Central Appalachian thermal coal generates 12,500 Btu, or
0.0125 MMBtu. With that information we can calculate that this mainstay
US thermal coal is currently priced at US$2.436 per MMBtu. Natural gas
is priced per MMBtu, so we can now compare our two fuels on a
dollars-per-energy-produced basis: over the same time frame, the Henry
Hub natural gas spot price has averaged US$2.188 per MMBtu.

So gas
is cheaper than coal, but not by much. In fact, on May 25 the Henry Hub
spot price was US$2.67 per MMBtu, making gas slightly more expensive
than coal on an energy-equivalent basis.

And the price to generate
each unit of energy is the only thing that matters to energy producers.
We contend that gas' price rally is over because if a rising gas price
renders the two fuels economically equivalent, the shift to gas will
end. Remember, coal was entrenched as America's power-generation
mainstay for many years, and that tenure leaves behind a legacy that
favors a return to coal – if the economics allow it. For example, many
US utilities are sitting on growing coal inventories. These utilities
are being forced to continue buying the fuel under long-term take-or-pay
contracts and will start burning it as soon as it makes sense to do so.
And limited storage space is making these stockpiles problematic: GenOn
Energy (NYSE:GEN), for instance, has declared force majeure on coal receipts due to a lack of storage space.

The
other, longer-term barrier to a natural-gas price rally is the huge
resources locked up in shut-in shales. As prices fell gas producers
reduced output, starting with the fields that generated the lowest
margins. The first on the chopping block: dry shales, which are
formations that produce only dry natural gas (also known as straight
methane), without much in the way of other byproduct fuels. Wet shales
or liquids-rich shales, by contrast, produce significant volumes of
heavier fossil fuels, like propane, butane, pentane, and even crude oil.
Low natural gas prices have rendered many dry gas wells uneconomic, but
the bonus production of natural gas liquids is keeping many wet gas
wells in the black.

While producers may not be tapping into these
dry shale resources right now, the resources themselves haven't
disappeared. Instead, these unloved dry shales have created a cap on
natural gas prices. As soon as prices move up enough to render dry-gas
production profitable, gas companies across the US will put their dry
shales back into production, creating another glut of supply that will
limit prices once again.

Coal is facing a similar situation. Coal
prices have to remain depressed in order for coal to remain competitive.
In short, the price of thermal coal in the United States is going to be
constrained – perhaps even controlled – by the price of natural gas for
the foreseeable future.

The Bottom Line

In
the United States, shale gas production will keep gas prices low for
years. Even a decline in stockpiles will do little to help – if prices
climb, producers will return to their shut-in wells, and supplies will
ramp up again. The massive volumes of natural gas sitting on reserve
books across the continent simply will not let prices rise very much for
a long time.

Constrained natural gas prices will keep a lid on
thermal coal prices. Once the king of America's power generation
machine, coal now has to compete with natural gas at every turn; and to
be competitive, it has to carry about the same price per MMBtu as gas.

Coal
and natural gas are very different, but in fact the two fuels are more
intertwined than one might think. The shale gas phenomenon has changed
the natural gas world fundamentally; the result has been that coal and
natural gas now compete for the same market. With abundant resources of
both available in North America, instead of making each other stronger,
coal and natural gas are holding each other down.

Unbelievable as
it may seem, there are ways to play this rivalry for handsome profits.
In fact, the entire energy sector appears poised to be the bull market of the 21st century. Don't let that opportunity pass you by.